Retiring on the edge of the fiscal cliff

10 ways to protect your retirement savings

One of the biggest risks that retirees and pre-retirees face is that of taxes; not just paying them but the risk that tax policy will change and throw a big wrench into one’s plans.

Well, that risk—in the form of the fiscal cliff—is now upon us and retirees and pre-retirees must now develop a plan of action for their portfolio should all, some, or none of the scheduled tax changes and spending cuts become a reality on Jan. 1.

“The ‘fiscal cliff’ may affect retirees, pre-retirees and the economy as a whole unless Congress acts,” said Thomas DiLorenzo, manager in the Employee Financial Services group at Ernst & Young LLP.

According DiLorenzo, increased taxes—higher income, higher dividend, and capital gains tax rates—are the primary personal finance concern as the Bush-era tax cuts are set to expire for all individuals. Among the changes:

In addition, the lower Alternative Minimum Tax (AMT) exemption that is currently in place for 2012 would result in many more individuals being subject to the AMT if the exemption amount is not increased as it has been in previous years..

While there is still time for Congress to take action and every individual’s situation will be different depending upon their facts and circumstances, experts including DiLorenzo said retirees and pre-retirees ought to consider the following given that the fiscal cliff might become a reality.

Things might get a little bumpy as we approach the fiscal cliff. So, Stephen Smith, a vice president at Noesis Capital Management, recommends that retirees and pre-retirees set aside 10 to 12 months of living expenses in a money-market fund. “That should provide a cushion so that their investment portfolio can be managed according to their respective time frame and circumstances, with less regard for volatility over a six-month period,” he said.

Rebalance assets

In the event that we do go over the fiscal cliff for more than just a few weeks of 2013, “the ramifications could be quite significant,” according to a UBS Wealth Management Report.

So retirees and pre-retirees might consider how they will allocate their assets given any number of scenarios that could play out as we near the fiscal cliff.

In a worst-case scenario, for instance, UBS reports that there will be severe double-digit losses for U.S. and cyclical non-U.S. equities; U.S. Treasuries and highly-rated non-U.S.-government bonds will rally and credit spreads will spike across the board; the U.S. dollar and other safe-haven currencies will rally; and there will be severe double-digit declines in the broad commodity indexes, with energy and base metals being the most affected.

In its report, UBS outlined four other possible scenarios, including a scenario where lawmakers design a best-case grand bargain that avoids the fiscal cliff. In this scenario, UBS predicts that there will be a rally in stocks, fueled by multiple expansion and stronger earnings growth; Treasury yields will rise modestly, but remain low; the U.S. dollar will rise; and commodities won’t fall.

Others, however, have a different point of view. “Although tax policy for 2013 remains highly contingent on the outcome of U.S. Presidential elections—we think that most likely scenarios continue to favor our themes of preferring large cap over small cap and dividend payers/growers over non-payers,” said Lisa Shalett, CIO and head of Investment Management and Guidance for Merrill Lynch Wealth Management.

Strategic asset allocation

While many agree that you need to develop a plan for the best- and worst-case scenarios, some suggest that you consider what’s called strategic asset allocation.

“Investors should, in my view, one, have a plan for what to do if valuation levels in the current stock market go up or go down substantially; and two, adhere to that plan—strictly,” said Ron Rhoades, assistant professor at Alfred State College and the president of ScholarFi Inc.

According to Rhoades, the current valuation level of the overall U.S. stock market is currently slightly below normal levels seen over the past 30 years, perhaps 0% to 10% below mean valuation levels. “Given the substantial rise in equities which has occurred this year, and the macroeconomic risks present, a prudent investor might desire to ‘take gains off the table’ at present,” he said. “This would be done by selling longer-duration bonds and/or equities, and reinvesting in short-term bond funds or CDs. This would serve to minimize the risk present in a downturn.”

Rhoades is not suggesting that investors time the market with tactical asset allocation. Rather, he suggests “adopting a prudent long-term strategic asset allocation and undertake tax-efficient rebalancing of the portfolio on a periodic, perhaps quarterly or semiannually, basis…This forces the investor to ‘sell high’ and ‘buy low’—to a degree.”

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.